Before the global financial crisis (GFC), liquidity risk was not on everybody's radar. Financial models routinely omitted liquidity risk. But the GCF has prompted a renewal to understand liquidity risk. One reason is because there was a consensus that the crisis included a run on the shadow (non-depository) banking system - providers of short-term financing, notably in the repo market - systematically withdrew liquidity; they did this indirectly but undeniably by increasing collateral haircuts. After the GFC, all major financial institutions and governments are acutely aware of the risk that liquidity withdrawal can be a nasty accomplice in transmitting shocks through the system (or even exacerbating contagion). (For more on liquidity, check out Understanding Financial Liquidity.) TUTORIAL: Liquidity Measurement Ratios

What is liquidity risk?
Liquidity risk is divided into two types: funding liquidity risk (aka cash-flow risk) and market liquidity risk (aka asset/product risk).

  • Funding (cash flow) liquidity risk is the chief concern of a corporate treasurer who asks: can we pay our bills, can we fund our liabilities? A classic indicator of funding liquidity risk is the current ratio (current assets/current liabilities), or for that matter, the quick ratio. A line of credit (LOC) would be a classic mitigant.
  • Market (asset) liquidity risk is asset illiquidity. This is an inability to easily exit a position. For example, we may own real estate but, owing to bad market conditions, it can only be sold imminently at a "fire sale" price. The asset surely has value, but as buyers have temporarily evaporated, the value cannot be realized. Consider its virtual opposite, a U.S. Treasury bond. True, a U.S. Treasury bond is considered almost risk-free as few imagine the U.S. government will default. But additionally, this bond has extremely low liquidity risk: its owner can easily exit the position at the prevailing market price. Small positions in S&P 500 stocks are similarly liquid. They can be quickly exited at the market price. But positions in many other asset classes, especially in alternative assets, cannot be exited with ease. In fact, we might even define alternative assets as those with high liquidity risk!

Market liquidity risk can be a function of the following:

  • The market microstructure. Exchanges (e.g., commodity futures) are typically "deep markets," but many over-the-counter (OTC) markets are "thin."
  • Asset type: simple assets are more liquid than complex assets. For example, in the crisis, CDOs-squared (CDO^2 are structured notes collateralized by CDO tranches) become especially illiquid due to their complexity.
  • Substitution (is the asset fungible?): If a position can be easily replaced with another instrument, the substitution costs are low and the liquidity tends to be higher.
  • Time horizon: If the seller has urgency, this tends to exacerbate the liquidity risk. If a seller is patient, then liquidity risk is less of a threat.

Note a common feature of both types of liquidity risk: in a sense, they both involve "not enough time." Illiquidity is generally a problem that can be solved with more time! (To learn more about risk, read Determining Risk And The Risk Pyramid.)

Figure 1: Measures of Market Liquidity

Measures of Market Liquidity Risk
There are at least three perspectives on market liquidity (see Figure 1). The most popular and crudest measure is the bid-ask spread; this is also called width. A low or narrow bid-ask spread is said to be "tight" and tends to reflect a more liquid market. Depth refers to the ability of the market to absorb the sale (exit) of a position. An individual investor who sells shares of Google, for example, is not likely to impact the share price; on the other hand, an institutional investor selling a large block of shares in a small capitalization company will probably cause the price to fall. Finally, resiliency refers to the market's ability to bounce back from temporarily incorrect prices. To summarize:

  • The bid-ask spread measures liquidity in the price dimension and it is a feature of the market not the seller (or the seller's position). Financial models that incorporate bid-ask spread adjust for exogenous liquidity and are exogenous liquidity models.
  • Position size, relative to the market, is a feature of the seller. Models that use this are measuring liquidity in the quantity dimension and are generally known as endogenous liquidity models.
  • Resiliency measures liquidity in the time dimensions and such models are currently rare.

At one extreme, high market liquidity would be characterized by an owner of a small position relative to a deep market who is exiting into a tight bid-ask spread and a highly resilient market.

What about volume?
Trading volume is a popular measure of liquidity, but it is now considered to be a flawed indicator. High trading volume does not necessarily imply high liquidity. The Flash Crash of May 6, 2010 proved this with painful, concrete examples. In that case, according to the SEC, sell algorithms (program trades) were feeding orders into the system faster than they could be executed. Volume jumped but many backlog orders were not filled. As the SEC wrote, "especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity."

A Common Method for Incorporating Liquidity Risk
In the case of exogenous liquidity risk, one approach is to use the bid-ask spread to directly adjust the metric. Please note: risk models are different than valuation models and this method assumes there are observable bid/ask prices.

Let's illustrate with value at risk (VaR). Assume the daily volatility of a $1,000,000 position is 1.0%. The position has positive expected return (aka drift), but as our horizon is daily we will bring our tiny daily expected return down to zero (a common practice). So let the expected daily return equal zero. If the returns are normally distributed, then the one-tailed deviate at 5.0% is 1.65; that is, the 5% left tail of normal distribution is 1.65 standard deviations to the left of mean. In excel, we can get this result with =NORM.S.INV(5%) = -1.645.

The 95% value at risk (VaR) is given by:

$1,000,000 * 1.0% volatility * 1.65 = $16,500

Under these assumptions, we can say "only 1/20 days (5% of the time) do we expect the daily loss to exceed $16,500." But this does not adjust for liquidity.

Let's assume the position is in a single stock where the ask price is $20.40 and the bid price is $19.60. In percentage terms the spread (%) = ($20.40 - $19.60)/$20 = 4.0%. The full spread represents the cost of a round trip: buying and selling the stock. But, as we are only interested in the liquidity cost if we need to exit (sell) the position, the liquidity adjustment consists of adding one-half (0.5) the spread. In the case of VaR, we have:

Liquidity cost (LC) = 0.5 * spread

Liquidity-adjusted VaR (LVaR) = position ($) * [-drift (%) + volatility *deviate + LC], or

Liquidity-adjusted VaR (LVaR) = position ($) * [-drift (%) + volatility *deviate + 0.5 * spread],

In our example,

LVaR = $1,000,000 * [-0% + 1.0% * 1.65 + 0.5 * 4.0%] = $36,500

In this way, the liquidity adjustment increases the VaR by one-half the spread ($1,000,000 * 2% = +$20,000).

The Bottom Line
Liquidity risk can be parsed into funding (cash-flow) or market (asset) liquidity risk. Funding liquidity tends to manifest as a credit risk: inability to fund liabilities produces defaults. Market liquidity risk manifests as market risk: inability to sell an asset drives its market price down, or worse, renders the market price indecipherable. Market liquidity risk is a problem created by the interaction of the seller and buyers in the marketplace. If the seller's position is large relative to the market, this is called endogenous liquidity risk (a feature of the seller). If the marketplace has withdrawn buyers, this is called exogenous liquidity risk (a characteristic of the market which is a collection of buyers); a typical indicator here is an abnormally wide bid-ask spread.

A common way to include market liquidity risk in a financial risk model (not necessarily a valuation model) is to adjust or "penalize" the measure by adding/subtracting one-half the bid-ask spread. (For more on Value at Risk, see An Introduction To Value at Risk (VAR).)

Related Articles
  1. Stock Analysis

    The 4 Technology Stocks You'll Wish You Bought in 2015

    Find out which technology stocks you wish you had bought in January 2015, including such big names as, Netflix and Electronic Arts.
  2. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  3. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  4. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  5. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  6. Investing

    What is EBITA?

    EBITA measures a company’s full profitability before reducing it by interest, taxes and amortization considerations, and so is useful for calculating a company’s internal efficiency or profitability ...
  7. Term

    What Is Financial Performance?

    Financial performance measures a firm’s ability to generate profits through the use of its assets.
  8. Investing

    How to Effectively Monitor Your Stock Holdings

    Investors should concentrate on the business, not the stock price.
  9. Investing Basics

    These Industries Have The Most Illiquid Stocks

    U.S. equity markets are vast and highly liquid, but a few sectors have failed to attract substantial capital.
  10. Investing

    Small Cap Investing: How to Think About Illiquidity

    Do your homework, have a long term view, exercise patience, you'll find that investing in small market capitalization stocks is no riskier than investing in large stocks
  1. What is liquidity risk?

    Liquidity risk has different meanings in different contexts. In investing terms, bondholders face varying liquidity risks ... Read Full Answer >>
  2. Are mutual funds considered cash equivalents?

    Though all mutual funds are considered liquid assets, only certain funds are considered cash equivalents. What Is a Cash ... Read Full Answer >>
  3. Are dividends considered an asset?

    Whether dividends paid on stock are considered an asset depends on which role you play in the investment: the issuing company ... Read Full Answer >>
  4. Why do mutual funds require minimum investments?

    Mutual funds require minimum investments to give mutual fund managers the liquidity and confidence they need to make you ... Read Full Answer >>
  5. What is a profit and loss (P&L) statement and why do companies publish them?

    A profit and loss (P&L) statement, or balance sheet, is essentially a snapshot of a company's financial activity for ... Read Full Answer >>
  6. How do dividends affect the balance sheet?

    Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!